Reasons Hedge Funds Fail by Mistakes Made

written by: jciotta•edited by: Jason C. Chavis•updated: 9/6/2010

Learn why hedge funds fail and the mistakes that can cause a hedge fund to fail. We discuss common mistakes to avoid for a potential hedge fund investor and how to determine what is a reputable investment.

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Beware of Hedge Fund Investing

Have you ever heard the saying, "If it's too good to be true, it probably is"? This is also representative of hedge funds.

A hedge fund is usually a private investment set up as a management portfolio. A group of investors puts money into the hedge fund, which is controlled by a hedge fund manager. The manager or other managers of the fund use aggressive financial strategies to increase their investments to millions, many times billions, of dollars. These aggressive strategies have a high amount of risk, but are supposed to be extremely profitable if managed correctly.

To enter or invest in a hedge fund, often times the investor must have at least a million dollars to put into the fund. That is why hedge funds are mostly for the very rich.

However, some hedge funds are poorly managed. Many funds start to invest heavily in leverage, or the amount of debt. This strategy can prove quite profitable if managed correctly, yet even the world's most renowned financial experts cannot control leverage when it spins out of control. For example, in the collapse of the 2004 Bailey Coates Cromwell Fund, bad stock choices prevailed. As a result, "...poor decision making involving leveraged trades chopped 20% off of a $1.3-billion portfolio in a matter of months. Investors bolted for the doors and on June 20, 2005, the fund dissolved..." (Investopedia).

Another significant hedge fund mistake is putting all your eggs in one basket. In other words, the risk is not spread out and the investment portfolio is not diversified. As any reputable financial adviser will tell the average Joe, he or she must have multiple investments. However, many hedge fund managers and investors decide to move all of the fund's money into one single investment. This is never a good strategy and often fails in the end.

Many of the largest hedge funds have collapsed due to arbitrage. Arbitrage is when an asset is both sold and purchased at the same time. Investors try to exploit the price difference between the sale and the purchase. This strategy is what brought on the most famous hedge fund collapse in history (to date). Long-Term Capital Management collapsed due to millions of dollars of investments in Russian markets. When Russia defaulted on its debt in 1998, Long-Term lost $4 billion -- all due to the arbitrage strategy. The most stunning part of this collapse was the managers behind the fund were Nobel Prize-winning economists and world renown financial experts.

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Common Mistakes to Avoid

Here are common mistakes to avoid when investing in a hedge fund:

As said above, is the manager offering something that is "too good to be true"? If so, walk away.

Is the risk spread? In a hedge fund, you will have high risk, but is it spread out into different investments?

Research on who manages the fund and their financial expertise. Is he or she a first time manager? A huge risk taker? Also, is this manager a reputable colleague and human being? Research who manages the fund thoroughly before giving a dime.

Ask about investment strategies. Does the fund rely heavily on leverage trading, shorting the market or arbitrage?

There is a red flag if the fund relies on arbitrage because in today's financial world, arbitrage is hard to pull off. Computerized trading systems have closed the gap on arbitrage exploitation. In literal seconds, arbitrage is spotted and eliminated.

As with mortgage-backed securities and the 2008 housing market crash, think about the future when you invest. For example, smart investors who realized all of the "no money down" and adjustable mortgage loans would eventually go bust, pulled their money out in time or never invested in mortgage-backed securities in the first place. If you see a hedge fund investing in an unstable, future market, don't invest.

The last thing to remember is to always use intuition. If it doesn't feel right, don't waste your time. It's always OK to walk away.

Now that you know why hedge funds fail and the mistakes that can cause a hedge fund to fail, you can invest wisely. If you have the money to put in a hedge fund, do your research carefully before investing. Always look before you leap, and with hedge fund investment, taking a long, hard look is the safest bet.